Interest rates may be turning upside down.

Upside-Down Interest Rates

Bad news for the U.S. that is worse news for the world.

Here's a bad sign: If current trends continue, we could soon be experiencing an inversion of the yield curve.

Though it sounds like something out of quantum physics, the yield curve is actually a fairly simple concept. It describes the relationship between interest rates on long-term and short-term U.S. government bonds. Interest rates on the shortest-term bonds correlate very closely with the interest rates set by the Federal Reserve Board. Long-term interest rates, by contrast, are influenced by many more factors, ranging from China's purchase of debt to investors' optimism about inflation and growth. Typically, bonds that mature further in the future pay higher yields—compensation for the risk of locking up money for a longer period.

Advertisement

When the difference between long-term and short-term interest rates is large, the yield curve is said to be steep. When the difference is negligible, it's flat. But when long-term rates are lower than the short-term rates, it's inverted. (On Smart Money's great yield-curve primer, you can click through the month-by-month interactive chart to see how the curve has shifted since 1977.)

The yield curve rarely inverts. And when it does, it usually spells trouble for the economy. It means that investors and the Federal Reserve are fretting about inflation in the short term, and that investors are pessimistic about long-term growth. According to Brian Reynolds, chief market strategist at MS Howells & Co., in the last 30 years, periods of prolonged inversion of the curve between two-year and 10-year government bonds have generally presaged recessions. The most recent period of inversion ran from February 2000 through December 2000—just before the 2001 recession.

A year ago, the yield curve was rather steep. But in the last year, the Federal Reserve Open Market Committee has taken the short-term Federal Funds rate from 1 percent to 3 percent in eight straight tightenings, the most recent one in May. (All the Fed's 2005 actions can be seen here.) Today, with two-year bonds at about 3.5 percent and the 10-year bond having fallen to about 3.9 percent, only a few dozen basis points separate the two.

The Fed could presumably ward off an inversion by stopping the short-term rate hikes. Yesterday, Richard Fisher, president of the Dallas Federal Reserve, told CNBC and the Wall Street Journal that the current phase of raising rates might be about done. "We've gone through eight innings here, 25 basis points an inning," he said, lapsing into baseball-ese. "The next meeting in June is the ninth inning."

But Federal Reserve Chairman Alan Greenspan, much more than Fisher, really determines whether the Fed will keep hiking rates. Investors and many analysts apparently expect further hikes, and thus a probable inversion. Investors use the Chicago Board of Trade's Federal Funds Futures to place bets on where they think the rate will be at certain times in the future. Today, traders are saying they believe that the rate will be 3.6 percent by November 2005, and about 3.7 percent by February 2006.

Rate hikes are also likely to continue because the Fed still has more work to do in carrying out its core mission—fighting off inflation. David Malpass, the chief economist of Bear Stearns, today pointed to sharply rising unit labor costs as a reason for the Fed to continue to maintain its vigilance. "We expect the Fed funds rate to end the year at 4.25 percent or 4.5 percent," he writes.

In the past, the combination of higher short-term rates and lower long-term rates has pointed to a nasty combination of higher costs and slower growth—which is bad for pretty much all companies. And an inverted yield curve will be especially bad news for some large financial institutions. Investment banks and hedge funds made out like bandits, with the carry trade borrowing short-term and buying long-term. This won't be possible in an inversion. J.P. Morgan Chase yesterday said its trading revenue—money made from investing the bank's own capital—would fall sharply this quarter.

But this time around, thanks to increased globalization and the ever-rising tide of international capital flows, an inverted yield curve may not necessarily mean bad news for the entire country. Yes, low long-term rates could signal that investors are pessimistic about the long-term prospects for U.S. growth. But many buyers of long-term government debt are overseas in China, Japan, and Europe. And from where they sit, our 3.9 percent-yielding 10-year bonds are a good deal. Look around the world, says Karina Mayer of ISI Group. Interest rates are trending lower everywhere throughout the developed world. In Japan, Europe, Taiwan, and Singapore, interest rates on 10-year bonds are significantly lower than they are in the United States. Only the United Kingdom, Canada, and Australia offer comparable rates. "Practically everywhere around the world, bond yields continue to trend lower, which is more of a reflection of slower growth," she says.

A yield curve that is becoming as flat as Kansas and threatens to invert may be a sign of slowing growth for the U.S. economy. That's the bad news. The good news: It's a sign that things elsewhere are probably much worse.